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Caught cold?

The interconnectedness of markets has often
been regarded as a double-edged sword. But research into the 6 May 2010 ‘flash
crash’ by Cass Business School suggests the ability of today’s information
technology to process data from multiple sources makes markets more liquid and
more vulnerable to shocks then ever.

In particular the research by Cass, part of
City University of London, calls for a new set of liquidity-based circuit
breakers to be implemented in addition to the price-sensitive shock absorbers put
in place after the crash.

The conclusions are set out in ‘Illiquidity
contagion and liquidity crashes’ by Dr Giovanni Cespa of Cass and Thierry
Foucault of HEC School of Management in Paris.

Cespa and Foucault argue that the near 1,000-point
price crash of 6 May was triggered by a sudden withdrawal of liquidity rather
than the other way round. In part due to market participants digesting
information from multiple markets, illiquidity can become contagious. So when a
large E-mini S&P500 futures order suddenly soaks up liquidity in that
instrument, feedback loops in today’s market can transmit that sudden
illiquidity to other markets. The academics note that on 6 May the decline in
the price of exchange-traded funds and their underlying securities preceded the
decline in prices for these securities. “The liquidity meltdown during the
flash crash reflects, at least partly, liquidity suppliers’ decision to curtail
they liquidity provision (e.g. by cancelling limit orders), and not only a
mechanical consumption of liquidity due to the arrival of sell market orders,”
they write.

In the immediate aftermath of the flash
crash, high-frequency traders in particular were harangued for exiting the
market when their liquidity was needed most, i.e. when prices were falling. If
Cespa and Forcault are right, liquidity providers, high-frequency or not, were
simply using information in one market to take rational decisions in another,
i.e. reducing their exposure to a potential price crash.

The paper does not point the finger at
‘cross-market arbitrageurs’. Instead, it points out that their ability to
offset risks in some market by taking offsetting positions in others relies on
the liquidity provided – or not – by specialised dealers in those markets.
Clearly such liquidity was not forthcoming on 6 May 2010.

Cespa and Forcault propose that price-based
circuit breakers be supported by liquidity-based circuit breakers that stop
trading when market-wide depth in a particular instrument drops below a
pre-specified threshold “to block an illiquidity spiral at its inception”.
However persuasive one might find the research, the complexity of imposing yet
further safeguards on the US markets mitigates against the introduction of
liquidity–based circuit breakers any time soon. The researchers decline to
comment on the likelihood of another flash crash in the meantime.